The proceeds have nothing to do with what is actually taxable. The gain is the difference between the adjusted cost basis and the selling price, regardless of any mortgage. The estate gets a stepped up basis on his death, so if the FMV was really $198,00 and the selling price was also $198,000, then there is no gain and no capital gains tax is owed by the heirs, regardless of the amount of cash that is realized.
It sounds like the IRS learned of the sale, and assumes (as they are allowed to) that the proceeds are taxable unless you prove otherwise. It sounds like you failed to file something. Sometimes, if no capital gains tax is owed, TurboTax will tell you that you don’t have to file the form with your tax return. This can be true in some cases, but if there was a 1099S issued at the closing, you must file and report the sale even though there is no gain. In other words, you have to show your work, and put on paper that there was no gain. Without showing your work, the IRS is allowed to assume that the sale was taxable.
At this point, it might be sufficient to send the IRS a written explanation, or you might need to file an amended tax return. It’s hard to know exactly without having the full picture.
